In a recent assessment of China’s economic outlook at the World Economic Forum, Zeng Peiyan, vice-premier of the People’s Republic, noted that China plans to achieve an average GDP growth of 7% a year for the next 20 years.
His optimism is neither exaggerated nor isolated. At virtually every turn today, observers paint China as an extremely attractive market, lacing their enthusiasm with forecasts for huge economic growth and compelling business opportunities.
Such predictions, coupled with a natural inclination to create businesses and the large numbers of engineers graduating from Chinese institutions-make conditions ripe for venture capital. This tantalizing premise hasn’t escaped the notice of American VCs. Venture investments in mainland or mainland-affiliated companies reached nearly $440 million in the first half of this year, up more than 30% from the same period last year. About 85% of this funding came from non-Chinese investors, according to Beijing-based Zero2IPO Venture Capital Research Center.
But even as the VC field grows crowded, American VCs may not fully grasp the difficulties of investing in China or the unique characteristics that should inform their decisions.
Based on seven years of investing in China, Intel Capital has learned a number of lessons-often, the hard way. The experience that Intel accumulated from closing nearly four-dozen deals in China may prove useful to VCs contemplating their own entry to this enormous, fast-growing marketplace.
First, a brief history. Since extending its venture capital program to China in 1998, Intel Capital has invested in some stellar successes, and some equally spectacular failures. Successful Intel-funded companies include UT Starcom, a pioneer in Chinese wireless telephony that’s now the world’s second-largest supplier of DSL equipment; Sohu.com, a Chinese portal much like Yahoo!; AsiaInfo, which built the operating support system for China’s telecom infrastructure (billing, subscriber management and so forth); and ChinaCast Communications, which delivers educational content to all parts of China via satellite. On a different note, Intel Capital also encountered a CEO who used our funds as collateral to secure a car loan, and a company that moved all its assets into a different corporate entity, with the assistance of its local investors.
The successful companies all grew into large businesses in their own right, mirroring the exponential growth in the Chinese market overall. Today, China is the second-largest market for PCs in the world, and the largest market for mobile telephones. Industry analysts estimate that China has between 325 million and 350 million wireless telephony subscribers-more than double the United States.
China is a lucrative market, but there are pitfalls. Experience teaches that many of those pitfalls can be avoided. Outlined below are eight key lessons Intel Capital has learned about investing in China. (Note: eight is considered an auspicious number in China.)
Lesson No. 1: Management will be hard to find. China doesn’t have the same managerial pool that we take for granted in the United States. CEOs and their direct reports are often returnees who have lived in the United States for five to 10 years, often attending graduate school here. These are typically good, solid business people who understand how American businesses run, how American investors think and how American management techniques work. Unfortunately, China doesn’t have many of them, and the best ones routinely move from one company to the next.
Finding middle managers who can translate high-level directions into action is even more difficult. Over centuries of imperial rule and 50 years of centralized planning, China has fostered a culture of hierarchical obedience. Consequently, many Chinese aren’t comfortable taking initiative, manifesting itself as a lack of understanding in basic business skills, such as decision-making, cost accounting, project management and time management. Bottom line: Expect to spend a lot of time recruiting and coaching.
Lesson No. 2: Reform is happening, in due time. It’s commonly said in China that the country is moving from a centrally planned economy to a “socialist market economy,” signaling that it’s not the kind of market economy Americans are accustomed to. China’s economy is undergoing a major transition that requires the wholesale creation of new regulations, institutions and practices. Many improvements are under way, but betting on future reform as a critical element of a business plan would be dangerous.
The convertibility of China’s currency, the Yuan (formally the “Renminbi”), offers a classic example. The Yuan is now pegged to the U.S. dollar at a ratio that many consider undervalues the Yuan relative to other currencies. Although the U.S. government is making a lot of noise, and some believe that China’s government will allow the Yuan to float, either freely or at least within a widened band, by the time Beijing hosts the Olympics in 2008, VCs would be unwise to invest with the expectation that this policy will change in a certain time frame.
Lesson No. 3: Learn to enjoy midnight board meetings. Working with people 13 to 16 time zones away means changing work habits. Be prepared for a different style of interaction with the CEO and other company leaders, and factor in a lot more travel than most VCs are accustomed to. Expect also that the difficulty of reaching consensus and alignment between the board and management on strategic and tactical matters will increase with distance, language and time differences.
Lesson No. 4: Fashion is the enemy of valuation. China has seen a heavy influx of foreign venture capital in the past year-mostly from the United States but also a measurable amount from Europe. Some investors may have placed huge sums of money on the table without fully understanding what goes on “behind the curtain” in China. Consequently, a lot of money is chasing too few enticing opportunities. If foreign investors continue to bid up the price of assets-people, equipment, plants and intellectual property-it follows that they will pay increasingly more for deals going in, and ROI is certain to suffer. Did anybody say “bubble?”
Lesson No. 5: Please don’t be a guailo. The Chinese have a long historical association with white-skinned foreigners who show up, tell them how to run the country and then leave. The pattern, and the pejorative Cantonese term coined to describe such offenders-“guailo” (or “guilao” in Mandarin)-dates back centuries. In China, guailos are considered ignorant and condescending, and their lectures insulting. This type of friction was painfully obvious at an investment conference earlier this year where first-time visitors from around the world sat at tables drafting a series of “recommendations” for the Chinese government intended to improve China’s VC industry. The credibility factor at this conference was as low as the confidence level was high. Bottom line: VCs need to be patient, listen, take the time to learn and form an understanding before offering comments, making decisions or dispensing advice.
Lesson No. 6: Expect a fickle business plan. If you believe you are accustomed to rapid change in Silicon Valley, brace yourself for China. In China, business plans change even faster than they do in America. Because China is growing so quickly, market conditions and opportunities change rapidly as well. To succeed, a startup has to adapt quickly to those changes, and VCs can’t expect the original concept they invested in to remain stable as the company matures. Milestone-based funding, for instance, is seldom appropriate, as the rapidly evolving business environment often makes the milestones themselves irrelevant before they can be met.
Lesson No. 7: Build your own guanxi. The Chinese word “guanxi” means literally “connections,” although it implies influence in both its positive and negative connotations. Think of building guanxi as developing a network of entrepreneurs, lawyers, consultants, co-investors, university experts and so forth who can provide sound, seasoned advice on venture capital in China.
Lesson No. 8: Think of your first mistakes as tuition. Intel Capital has achieved excellent financial results in China despite making its share of mistakes, but we understand that’s part of the cost of doing business. To minimize this cost, our strategy has always been to capitalize on the experience of others by co-investing. We welcome interest from VCs looking for partners.
One other point worth mentioning here is that Intel Capital has learned not to invest in companies whose key business strategy is to leverage lower costs in China. Fundamentally, lower costs are only a temporary state of affairs; a company that’s low-cost today may not be lowest-cost two years later. With this in mind, Intel Capital is much more interested in companies that can lay claim to deep technical knowledge, intellectual property and the ability to invent.
Experience suggests that investment opportunities in China are only likely to improve over time. The choices are already broad today, ranging from semiconductor companies targeting digital television and wireless telephony, to system integrators who help large Chinese enterprises adopt computers to manage their operations. Other potential investment opportunities in China include designers and manufacturers of cell phones; companies developing voice over IP (VoIP) software and triple play software; producers of networking equipment; and soon, software developers – assuming the intellectual property situation becomes a little less murky.
Traditionally, VC-funded companies in China serve the domestic market, but the country is at an inflection point. We are witnessing the beginning of the next revolution in China-the creation of domestic technology that will be usable worldwide. Chinese companies have begun building world-class products and services with the aim of competing against established players in the worldwide market. They stand every chance of success.
Claude Leglise is Vice President of Intel Capital and manages Intel’s international investment program. His email is firstname.lastname@example.org.